The invention relates generally to improving liquidity for equity interests that cannot be efficiently monetized, by dividing up the cash flows from the equity interests and efficiently distributing them among different classes of investors.
Interests in private, Alternative Investment Funds (“AIFunds”) can be highly illiquid. As used herein, Alternative Investment Funds (“AIFunds”) include, but are not limited to, equity interests in private equity funds; hedge funds; leveraged buy-out funds; venture capital funds; partnerships; real estate investment trusts; as well as positions in illiquid assets such as real estate, or stock in private companies, for example.
Investors expect that higher returns will compensate them for this illiquidity. For example, many general partners (GPs) raise capital from limited partners (LPs) for their AIFunds. The GP uses his expertise to invest the funds, seeking a high return. Each fund will typically be invested in a portfolio of interests. Much of the economic value GPs contribute for AIFunds is connected with their willingness to make illiquid investments. Such investments are only possible because LPs have committed their funds for extended periods. GPs usually earn a management fee, and a carry, i.e., a portion of the profit earned on invested funds.
LP investors are typically institutional investors and wealthy individuals. LPs generally expect returns from AIFunds of as much as twenty percent per year. However, actual returns from AIFunds are highly variable. Cash flow will generally be distributed after a realization event, such as the sale of a company or an initial public offering (IPO). LP distributions can be made over a long period of time and the timing is unpredictable.
Today, there are an enormous number of LPs that would like to reduce their exposure to AIFunds. However, none of their options are attractive. The buy-side of the market for participations in AIFunds is developing, but at this point, there is still a substantial imbalance with much greater sell side pressure. Historically, the market for participations was quite thin, with brokers attempting to match buyers and sellers for particular positions. Today, the chief buyers for the Primary Fund participations are the new funds raised to purchase secondary market participations (“Secondary Funds”). Such funds offer diversification across many different funds, industry groups and vintage years. Billions of dollars have been raised for Secondary Funds, but bids for Primary Fund participations are still quite low. To understand why, it is useful to think through the process. There is substantial inefficiency at every step.
First, the market for AIFund participations is small and inefficient. An excellent measure of market efficiency is bid/asked spreads. Characteristic of small, illiquid markets with little transparency, bid/asked spreads in the AIFunds market are very wide.
Second, selling pressure has overwhelmed investor demand for AIFund participations. The general drop in equity prices has hurt all investors. However, technology has been particularly hard hit, and those seeking high returns in technology are the same investors who purchased participations in AIFunds. Having entered with great optimism, expecting high returns, these investors now are confronted with very heavy losses from technology, a much higher percentage of ‘alternative investments’ than is prudent, and much constrained liquidity. The order imbalance for AIFund participations is manifest in various ways. Most AIFund GPs mark their positions to market, but bids for purchasing those positions are usually at a substantial discount to the GP Net Asset Values (“NAVs”). The discounts systematically exceed by a wide margin any unwarranted optimism of fund managers. A buyer pricing an AIFund participation starts with a bottoms-up analysis of direct investments to determine future cash flows. Obviously, projecting cash flows is a very subjective process that is likely to be influenced towards excessive caution by the large sell-side overhang. New AIFunds have a typical expected return of high teens to 20%. One of the most active current purchasers of AIFund participations acknowledges that its prices for participations are computed to yield investors in its Secondary Fund 25% returns, after fees. This Secondary Fund manager freely admits that even when it agrees that the GP has fairly priced AIFund participations, it consistently bids substantially less than GP valuations.
An additional inefficiency is that much of the new liquidity for AIFund participations is illusory. At any given time, there is a limited pool of money available to purchase alternative investments. Though Secondary Funds are being sold, very few new investors are being drawn into the AIFunds market. Instead, the ownership is simply being shifted from weak hands to stronger hands. Secondary Funds have not changed the risk characteristics of AIFund investments in a way that will bring in new investors. That is, “strong hands” might be characterized as an individual or entity that can maintain the illiquid investment of an AIFund for substantial return in the future, i.e., possible years in the future. In contrast. “weak hands” might be characterized as an individual or entity that was overly optimistic in investing in an AIFund, and needs liquidity before his investment is returned from the AIFund. This can be true even though the weak hands know that long term profits would be substantial, i.e. if they were not forced out by their immediate short term liquidity needs.
To explain further, prior to the fall in markets of the recent past, it can be assumed that ‘strong hands’ held an optimal amount of AIFund investments. With the unexpected fall in equity markets, their ownership of AIFunds was pushed towards a sub-optimally large percentage. Notwithstanding, the ‘strong hands’ held their positions because the risk-adjusted cost of selling was too high, i.e., their expected return of the marked down positions compensated for the incremental risk.
Secondary Funds are sold almost exclusively on the basis of price. The same ‘strong hands’ are now buying into the new Secondary Funds because the expected returns are high enough to compensate them for a larger then normal concentration in AIFunds. Expected returns must overcome their risk of excessive concentration. Despite relative inelasticity of demand, if the price gets cheap enough, buyers will be attracted.
A further inefficiency of Secondary Funds is that AIFunds offer little transparency into the value of participations. Each fund has numerous individual investments, for which only the GP has full information. In addition, only the GP can control the timing of liquidity events. In the absence of control or information, buyers of AIFund participations must build in a large risk premium for their uncertainty.
Yet an additional inefficiency is that new Secondary Funds impose a second layer of fees. Secondary Fund GPs must compete with normal AIFunds for investors. The assets of primary AIFunds and Secondary funds are very similar, and Secondary Fund GPs must be compensated. As a result, bids for AIFund participations fully discount Secondary Fund fees, i.e. sellers of AIFund participations are likely to bear the full cost of GP fees for the Secondary Funds.
A further difficulty is that investors are reluctant to take losses. Recognizing losses is difficult for all investors. Crystallizing the realization of losses is a discipline that is hard even for seasoned traders. Institutional holders are very much affected by the accounting consequences of selling participations at a loss. The consequence is that investors postpone recognition of losses as long as possible. When investors have no choice but to lighten up their investments in AIFund participations, frequently they must raise cash quickly.
Furthermore, recently proposed arrangements have very limited value. Currently, there are a number of arrangements to mitigate the immediate accounting consequences of getting liquidity for AIFund positions. Usually, the result is that losses are spread over a period of years instead of being taken all at once. However, the true economic cost is not diminished.
An additional difficulty arises because GPs are reluctant to approve transfer of LP ownership interests. GPs must usually approve all transfers of ownership for participations. GP's have several disincentives to approve such transfers. One disincentive is that transfers of LP interests directly compete for investors with future sales by the same fund managers. If a AIFund approves a transfer, that AIFund loses the opportunity to sell a future fund to an investor that likes a specific fund manager.
A further disincentive is that many funds would like to keep performance information closely held among their existing investors. Transfer of participations distributes more widely that information. This is particularly sensitive now, because it is the performance of their least successful funds that will likely become better known. A yet further disincentive for a GP to approve such transfers is that many funds like to foster the notion that their LPs form a tight, exclusive group. GP's want investors to believe there is scarcity value to their funds and that it is a privilege to be able to invest with them. Remarketing of participations reduces that exclusivity a lot.
A further difficulty arises because the new Secondary Funds have very specific investment criteria. The new Secondary Funds must distinguish themselves from AIFunds. One means is to focus on the excess returns available because of the market imbalance. However, another big selling point is the fact that Secondary Funds are largely invested, and return of capital is expected much quicker than for primary AIFunds. Typical Secondary Funds seek on average to buy participations that are at least 70% funded. With the run up of the markets, the amount of capital invested in AIFunds rose exponentially in recent times. In addition, many of the funds raised since 1999 are viewed as suspect by investors, fearful that GPs bought positions at inflated values. AIFunds raised since 1999 far exceed the size sold earlier. Many of the recent funds are less than 50% committed. Thus, a substantial percentage of Primary Fund participations do not fit the criteria for purchase by Secondary Funds.
Finally, the origination and distribution costs for Secondary Funds are high. Raising funds is always costly, and despite the selling pressure, it is expensive to acquire assets for Secondary Funds. Buyers of secondary participations must: i) carefully evaluate each of the underlying positions and project their cash flow, with little direct information; ii) overcome the reluctance of investors to recognize losses, and their sticker shock at the bid; iii) obtain the GP's approval to transfer of participation ownership; and iv) attract new investors into a distressed sector of the market.
As a result of these known difficulties and inefficiencies, various solutions have been proposed for addressing the liquidity problem. To date, the market has offered just a few mechanisms to provide AIFund investors with liquidity: i) at great cost, brokers match buyers and sellers for individual participations; ii) more recently, Secondary Fund GPs buy AIFund participations for their funds; iii) occasionally, buyers have offered arrangements that either mitigate the accounting impact of losses, permit participation sellers to retain and shape some residual risk position; and iv) a very few leveraged transactions were placed that included one debt tranche supported by an insurance wrap, with the remaining portion constituting leveraged equity in AIFund participations. The latter transactions have not been successful recently for lack of buyers of the leveraged equity piece.
Recently, a new arrangement, the principal protected note, has been brought to market. The appeal of this product is chiefly regulatory arbitrage. Through an economically inefficient ruse, investors are able to pretend that potentially high yielding AIFund investments are high quality debt instruments. A recent example is a $500 MM 15-year note incorporating an insurance wrap (essentially, 50% downside protection of the portfolio value) that will permit domestic insurance companies to carry their investment based on the regulatory capital of a AAA note. Investors receive exactly the return of the AIFund cash flows, less the premium paid to the insurance company.
Unless new investors are brought to the AIFund participation market, the sell-side pressure will grow even greater. There will be increasing competition for the few ‘strong hands’ buyers left standing. To compensate for increasing concentration risk, with each new purchase, remaining buyers will raise their investment hurdle rate. Price has been and will continue to be the only means of attracting investors.
AIFunds have been discussed above and liquidity problems associated with those AIFunds. Problems are also present, in known techniques, with AIFunds in the corporate context. To explain, in accordance with further aspects of the Background of the Invention, corporations typically have a corporate capital structure that permits different types of loans, such as loans secured with assets, unsecured loans, subordinated loans, etc. From an equity perspective, there can be common and preferred stocks. The rights and entitlements of each class of equity can be quite variable regarding such issues as voting, conversion, control and preference. Creation of new preferred stock requires issuer participation, and is complicated because the approval of all securities subordinated by the new issue must usually be sought.
Further, the underlying asset for CDOs, CLOs and CMOs (collatorized debt obligations, collatorized loan obligations and collatorized mortgage obligations), for example, may typically be a portfolio of various debt instruments. The priority/tranche technology was developed to finance these portfolios more efficiently, i.e., wherein the underlying assets are debt. Instead of selling the generic, bundled exposure of the debt portfolio, different classes of investors, each with different risk reward and/or investment outlooks are offered interests tailored to their particular preferences. The aggregate cash flow arising from the portfolio of debt in the securitized issue is distributed based on a “waterfall” of priorities. Each separate cash flow “tranche” has a given priority of claims regarding repayment, e.g. the senior most tranche might have a rating of AAA, while the junior most might have the risk characteristics of junk bonds or equity. However, various shortcomings exist with known techniques in the situation when a general partner of an Alternative Investment Fund desires liquidity, but cannot borrow against stock pursuant to Alternative Investment Fund powers.
In view of the deficiencies in the solutions described above, a method and system is needed for efficiently introducing liquidity into AIFund investments.